I would have thought that all the shenanigans within the financial industry ended when regulators began looking into causes of the Great Recession. Today, the SEC announced that JPMorgan Chase is settling the charges that lying to investors was part of the method of operation for the company as late as the first quarter of 2012.
The company is settling for a penalty of $200 million, but this amount is added to recently settlements with other regulators and agencies for a total of $900 million.
JPMorgan Chase’s behavior that attracted SEC scrutiny
The SEC charges relate to a specific incident in March 2012. One of the divisions of JPMorgan Chase managed a portfolio designed to “hedge against adverse credit events.” In other words, if companies were to default on their own bonds on a large scale, this investment would increase in value. With a broad view, hedging is an important financial strategy, and every company should find a way to hedge against downward trends.
When you hedge, your performance should move in opposition to whatever forces you’re hedging against. Everyone else’s good news could be this portfolio’s bad news, and that’s precisely the case in the first quarter of 2012. At the end of March 2012, the stock market had just completed its best performing quarter since 1998. Meanwhile, the credit hedging portfolio at JPMorgan Chase started losing a lot of money.
According to the SEC, the traders involved with this portfolio decided to change how they were calculating the losses they were reporting to management. Previously, the traders would choose a price for each investment within the portfolio using a set of parameters that was understood and accepted. The price reported would simply be the mid-point within the spread between the bid and ask prices for each investment — a nice compromise. But when those prices reflected significant losses on a daily basis, a senior trader instructed a junior trader to stop reporting losses. So the junior trader came up with a new strategy.
The junior trader chose to report the most favorable price — the price that reflected the smallest loss — even if that price was outside of the spread. Using this pricing scheme to the company’s advantage when filing its quarter-ending financials with regulators and investors, JPMorgan reported a loss of only $138 million in that portfolio. The company later restated its financials, admitting it found fault in the calculation at the time, and the loss climbed by an additional $660 million.
An independent review later found that there would be an increase in loss of over $1 billion if the investments had been marked independently. The SEC further alleges that JPMorgan Chase lacked the communication and controls necessary to keep upper management aware of the fraud that had been occurring at the trader level. But you can’t put full blame on one or two rogue traders.
Blame the traders, blame the management, or blame the system?
Quarterly results can kill or crown companies. Wall Street puts pressure on many publicly-traded companies — especially those that operate on Wall Street — to produce outstanding results in the short-term. When the stock market as a whole is providing fantastic results, reporting one division with substantial losses is a surefire way to draw negative attention. People can get fired for bad results. Derivatives traders, who earn a substantial income and might use that income to live a life with their families one might not considered frugal, have a lot to lose.
Like Walter White, they might justify harmful behavior by wanting to provide for their family as much as possible. Their jobs are on the line every quarter; they want to be successful to protect themselves. If they can’t be successful, they want to appear successful.
When the hedge works in the expected direction, that is, when the underlying markets perform poorly and the hedging portfolio goes up in value, the derivatives traders are heralded as heroes. But if the derivatives continue to do their jobs as investments, the will be a financial sinkhole when the underlying markets improve. When this reality combines with the pressure to outperform all the time, there can be some temptation to adjust the numbers to be as favorable as possible to save one’s own job.
It’s this short-term, departmentalized culture that is a danger to companies in the long-term, and it’s a reason why much of Generation Y doesn’t trust Wall Street.
Management put their heads in the sand. They trusted the reported numbers from these traders, but what choice do they have? Management can’t oversee every price of every investment in every portfolio. But internal auditors can.
When I worked for a financial company, profit centers that did not report a high enough return on equity or income each quarter were in danger of being jettisoned from the organization — and this happened several times while I worked there. People’s livelihoods were changed when changes in the market resulted in poor performance in any one department despite the fact that the whole company was in good shape and losses in one area were offset by gains in another. Departmentalization requires every business unit to be profitable on its own, but singularly-focused departments, like an investment team concerned with one specific piece of the market, can’t do that every quarter.
This $200 million penalty may be so low because JPMorgan Chase has already changed its policies and restated its financial reports. But I’m not convinced that any problem has been solved here. Culture will continue to dictate that individuals within a company will willing to bend the rules in order to meet internal and external pressure for performance.
Here is the full SEC order in which the regulator describes the events leading up to the fraud in March 2012 and orders JPMorgan to change its policies and pay the $200 million penalty.
Published or updated September 19, 2013. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.